Lecture 4 Extensions to the Open Economy and Emerging Market Crises Mark Gertler NYU June 2009 0
Objectives Develop micro-founded open-economy quantitative macro model with real/financial interactions Application to modeling emerging market crises Implications for fixed versus flexibile exchanges. Illustrate the general relevance of monetary policy for financial propagation mechanisms.. 1
Approach (Based on Gertler, Gilchrist Natalucci, 2007)d Develop small open economy variant of the financial accelerator model of Bernanke, Gertler and Gilchrist (1999). Use the framework to model the 1997-98 Korean crisis Study the performance of alternative monetary policy regimes 2
Background Motivation Each of the major international capital market-related crises since 1994 - Mexico, in 1994, Thailand, Indonesia and Korea in 1997, Russia and Brazil in 1998, and Argentina and Turkey in 2000-has in some way involved a fixed or pegged exchange rate regime. Exchange Rate Regimes: Is the Bipolar View Correct? Stanley Fischer, January 6, 2001. 3
Background Motivation Recent crises (Kaminsky and Reinhnart (1999)) Link between financial crises and currency crises: Fixed exchange rate regime (often) forces interest rates to adjust in a manner that amplifies the crisis. Features of historical crises (Eichengreen (1992)): During the Great Depression, countries that did not abandon the gold standard early suffered: More severe economic downturns. More severe financial crises. 4
1997-1998 Korean crisis: Summary Onset: Fixed exchange rate regime prior to crisis 5% rise in country risk premium. Monetary policy initially defended fixed rate, producing a sharp rise in the call money rate 5
1997-1998 Korean crisis (con t) Effect on real side of the economy: SharpdropinrealGDP(-14%). Collapse in investment spending (-45%). Fall in labor productivity (-5%). 6
Effect on financial markets: 1997-1998 Korean crisis (con t) Collapse in stock market (-50%). Sharpriseincorporatebondspreads(9%). Currency depreciation (-70%). 7
Figure 1A Korean Data Real GDP* Real Gross Capital Formation* 0.10 Quarterly 0.4 Quarterly 0.05 0.2 0.0-0.05-0.2-0.10-0.4 1996 1997 1998 1999 1996 1997 1998 1999 Total Employment* Real Consumption* 0.06 Quarterly 0.10 Quarterly 0.04 0.02 0.05-0.02-0.05-0.04-0.06-0.10-0.08 1996 1997 1998 1999-0.15 1996 1997 1998 1999 Real GDP per Worker* Electricity Consumption* 0.04 Quarterly 0.10 Quarterly 0.02 0.05-0.02-0.04-0.05-0.06 1996 1997 1998 1999-0.10 1996 1997 1998 1999 * Series are shown on a log scale and are detrended.
Figure 1B Korean Data 10 Percent EMBI Global Korea Daily 10 Corporate Credit Spread* Percent Monthly Average 8 8 6 6 4 4 2 2 0 0 1996 1997 1998 1999-2 1996 1997 1998 1999 30 Percent Overnight Call Rate Monthly Average 10 Percent CPI Inflation** Quarterly 25 8 20 6 15 10 4 5 2 0 1996 1997 1998 1999 0 1996 1997 1998 1999 1800 Korean Won to US Dollar Monthly Average 1200 Stock Prices (KOSPI) Scale, Apr. 1980=100 Monthly 1600 1000 1400 800 1200 1000 600 800 400 600 1996 1997 1998 1999 200 1996 1997 1998 1999 * The line depicts the difference in yields between a 3-year corporate bond and the Treasury security of corresponding maturity. ** CPI inflation is year-over-year growth.
Figure 1C Korean Data 20 Percent of GDP Net Exports Quarterly 0.2 Trade-Weighted Real Exchange Rate* Quarterly 15 0.1 10 0.0 5-0.1 0-0.2-5 -0.3-10 1996 1997 1998 1999-0.4 1996 1997 1998 1999 Real Exports* Real Imports* 0.10 Quarterly 0.3 Quarterly 0.2 0.05 0.1 0.0-0.1-0.2-0.05-0.3 1996 1997 1998 1999-0.4 1996 1997 1998 1999 * Series are shown on a log scale and are detrended.
Model Description: DSGE small open economy framework. A variant of Gali/Monacelli with Capital; Financial accelerator à la BGG (1999); Variable capital utilization to capture TFP movements. 8
Sectors within the home country: Households Business sector: Entrepreneurs (wholesale goods) Capital producers Retailers (final goods) Foreign sector Central bank 9
Domestic and foreign goods: Consumption is composite of domestic and foreign tradables: C t = (γ) ρ 1 µ CH,t ρ 1 ρ +(1 γ) 1 ρ µ CF,t ρ 1 ρ ρ ρ 1 Price indexes P t = "(γ) µ P H,t 1 ρ +(1 γ) µ PF,t 1 ρ # 1 1 ρ 10
Household s preferences: E 0 X t=0 β t (Ct ) 1 φ (1 L t ) φ 1 σ U( ) 1 σ 11
Household s budget constraint P t C t + S t B t+1 + B t+1 = W t L t + S t Ψ t 1 ³ 1+i t 1 B t +(1+i t 1 ) B t + Π t T t with Ψ t > 1 if B t < 0 = 1 if B t 0 12
Household optimality conditions Consumption/saving: λ t = βe t λ t+1 (1 + i t ) P t P t+1 λ t =(1 φ)(c t ) (σ 1)(φ 1) 1 (1 L t ) φ(1 σ) Uncovered interest parity condition: E t λ t+1 P t P t+1 (1 + i t ) Ψ t (1 + i t ) S t+1 S t =0 13
Household optimality conditions (con t) Intra-temporal consumption allocation: C H,t C F,t = γ 1 γ P F,t P H,t ρ h Labor supply: (1 φ) 1 C t W t P t u = φ 1 1 L t 14
Foreign sector Baseline ForJ=H,F:Lawofoneprice: P J,t = S t P J,t Foreign demand for domestic tradables: Ã P CH,t! ξ = H,t Pt Ct (1 + i t ),P F,t P t,c t are exogenous. We also consider local currency pricing with imperfect pass through and slow adjustment in foreign demand 15
Entrepreneurs Produce wholesale goods using labor and capital services Y t = ζ t A t (u t K t ) α (L t ) 1 α Borrow to obtain capital: Face credit market frictions Risk neutral agents with finite expected horizon face γ survival probability 1 1 γ expected life time. 16
Variable Input Demands Labor demand: P W,t P H,t (1 α) Y t L t = W t P H,t Optimal capital utilization: P W,t P H,t α Y t u t = δ (u t ) 0 K t P i t P H,t 17
Expected Return to Capital E t n Rkt+1 o = E t { P Wt+1 P t+1 α Y t+1 K t+1 + " # Qt+1 δ (u t+1 ) }/ Q t P t+1 P t 18
Capital Demand If debt is in units of domestic currency. with E t n Rkt+1 o =(1+χt ( )) E t (1 + i t ) P t χ t ( ) = χ Q tk t+1 N t χ 0 ( ) > 0, χ(0) = 0, χ( ) = P t+1 19
Capital Demand (con t) If debt is in units of foreign currency ( ª E t Rkt+1 =(1+χt ( )) E t Ψ t (1 + i t ) S t+1 S t P t P t+1 ) 20
Evolution of net worth (with debt in local currency) with N t+1 = γv t +(1 γ)d V t =(1 m t )R kt Q t 1 P t 1 K t R kt =( P W t P t α Y t K t + " (1 + i t 1 ) P t 1 P t " # Qt (1 δ (u t ) )/Q t 1 P t # Bt P t 1 21
Evolution of net worth (with foreign denominated debt) Entrepreneurial net worth Q V t = R t 1 kt K t P t 1 ³ (1 + χ( )) Ψ t 1 1+i S t P t 1 S t 1 Bt 1 t 1 S t 1 P t P t 1 An unanticipated depreciation (increase in S t ) reduces net worth, 22
Capital producers (competitors) New capital: with Φ 0 > 0, Φ 00 < 0. Capital Accumulation K t = Φ Φ Ã! It K t Ã! It K t K t K t +(1 δ(u t ))K t Tobin s Q Q t P H t+1 Φ 0 I K I t 1 =0 K t 23
Retailers (monopolistic competitors) Buy wholesale output and sell as differentiated final product. Set prices on a staggered basis (a la Calvo (1983)). Domestic inflation: P H t P H t 1 = Ã μ P W t P H t! λ P H t+1 E t Pt H CPI inflation. P t P t 1 = P t H Pt 1 H γ Ã St S t 1! 1 γ 24
Monetary policy Fixed exchange rate regime: S t = S t 1, t = i t = Ψ t i t Flexible exchange rate regime: Open economy version of the Taylor rule. Ã (1 + i t )= (1 + r ss P c ) t Pt 1 c with γ π c > 1 and 0 τ<1. "! γπ c # 1 τ (1 + i t 1 ) τ Switching regime. Begin in fixed, abandon with fixed probabiliy Π. 25
Parametrization Quantitative analysis meant to be suggestive Korean data when possible. Capital markets less developed relative to U.S.: SS external finance premium roughly 150 basis points higher than U.S. data Debt-equity ratio is 50% higher than historical U.S. data Exports share of domestic output set at 40% Capital share is 50 percent 26
The Korean experiment 5% shock to country-risk premium. ρ =0.95. Alternative monetary policies to consider: Fixed exchange rates. Initially fixed exchange rates, but abandoned probabilistically. Low abandonment probability Π =0.1. See Krueger et al. (2001). Switching exchange rate regime: abandon earlier than expected (one quarter) economy experiences good news and asset prices rise. 27
Figure 2A Korean Crisis Experiment Output Investment 0.0-0.02-0.04-0.1-0.06-0.08-0.2-0.10-0.12 Flexible Exchange Rate Regime Switch Fixed Exchange Rate -0.3-0.14-0.4 Capital Utilization Rate Labor Productivity 0.05-0.01-0.05-0.02-0.10-0.03-0.04 Household Consumption Net Exports 0.04 0.16 0.02 0.14 0.12-0.02-0.04 0.10 0.08 0.06-0.06 0.04-0.08 0.02-0.10 Note. Model s response to a Country Risk Premium Shock.
Figure 2B Korean Crisis Experiment Nominal Interest Rate Real Interest Rate 0.15 0.10 0.05-0.05 Flexible Exchange Rate Regime Switch Fixed Exchange Rate 0.15 0.10 0.05-0.05-0.10 CPI Inflation External Finance Premium 0.08 0.12 0.06 0.10 0.04 0.08 0.02 0.06-0.02 0.04-0.04 0.02-0.06 Nominal Exchange Rate Real Exchange Rate 0.16 0.12 0.14 0.10 0.12 0.08 0.10 0.08 0.06 0.06 0.04 0.04 0.02 0.02-0.02 Note. Model s response to a Country Risk Premium Shock.
Figure 3 The Amplification Effect of the Financial Accelerator Regime Switch Experiment Output Investment 0.0-0.02-0.04-0.1-0.06-0.08-0.2-0.10-0.12 With Fin. Accelerator Without Fin. Accelerator -0.3-0.14-0.4 Labor Productivity Hours 0.02-0.01-0.02-0.04-0.02-0.06-0.03-0.08-0.10-0.04-0.12 Note. Model s response to a Country Risk Premium Shock. The case without the financial accelerator mechanism corresponds to χ t = 0 for all t.
Figure 4 The Role of Utilization Margins Regime Switch Experiment Output Labor Productivity 0.12-0.02 0.10-0.04 0.08-0.06 0.06 0.04-0.08 0.02-0.10-0.12 Variable Capacity Utilization Fixed Capacity Utilization -0.02-0.14-0.04 Note. Model s response to a Country Risk Premium Shock. In the case without variable capacity utilization, µ t = 1 for all t and k is equal to zero.
Figure 5 The Role of Frictions in the International Sector Regime Switch Experiment Real Exchange Rate Net Exports 0.12 0.16 0.10 With Frictions Without Frictions 0.14 0.08 0.12 0.06 0.10 0.08 0.04 0.06 0.02 0.04 0.02-0.02 Note. Model s response to a Country Risk Premium Shock. In the case without frictions, we eliminated trading frictions owing to inertia in foreign demand (i.e., ν = 1) and nominal rigidities for foreign goods at the retail level.
Figure 6 Foreign Denominated Debt Output Investment 0.0-0.02-0.04-0.1-0.06-0.2-0.08-0.10-0.12-0.14 Flexible rates, domestic-denominated debt Flexible rates, foreign-denominated debt Fixed rates -0.3-0.4-0.5 Note. Model s response to a Country Risk Premium Shock.
Conclusions Exercise does well at matching key features of Korean crisis. Matches real side reductions in spending and rise in external finance premia. Endogenous financial collapse through financial accelerator accounts for over 50% of output movement. Model implies endogenous fall in labor productivity warning against arguing that productivity is driving force in crisis. 28
Policy implications: Ex post abandonment nearly as bad as remaining on fixed exchange rate following crisis not a good substitute for ex ante flexible rates. Flexible rates desirable even with dollar denominated debt owing to debt overhang and need to finance existing capital stock. Main Caveat We ignore possible credibility value of fixed exchange rates. 29